2 Mortgage-Backed REITs To Avoid In 2015

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Includes: ARR, CYS
by: AH Research

Summary

Fed will be cautious in raising rates as long as slacks continue to exist in labor market.

Global macro-economic environment is not suitable.

ARR’s and CYS’ core EPS will remain pressurized due to defensive approaches.

Both have already reduced dividends and may do so again later on.

In this article, I will be discussing two Mortgage-Backed REITs that I believe should be avoided by investors in 2015. I believe that interest rates will remain low for longer than anticipated by the market due to slacks in labor market, low inflation and weakness in global economies. Therefore, I believe RMBS companies should take more risk and adjust their portfolios as economic data improves and the Fed's targets are met.

The two companies I advise investors to avoid are ARMOUR Residential (NYSE:ARR) and CYS Investments (NYSE:CYS). Both companies continue to position their portfolios defensively with significant investments in low-yielding 15-year and 20-year MBS securities. Furthermore, both are heavily hedged. These initiatives will continue to pressurize EPS, and the company has failed to take advantage of the low interest rate scenario.

Why The Fed will not raise Interest Rates

The Fed, in its last meeting, made it clear that it would be patient in raising interest rates, and the end of the expansionary policy would be dependent on U.S. economic data and not a calendar date. The slacks in the labor market, namely the labor force participation rate and average wage rate, are nowhere close to pre-recession levels. The labor force participation rate is just 10bps higher than its lowest level since 1978. Similarly, the rise in average wage rate is also accompanied by a rise in average work week and income inequality. So, the $0.09 rise in average wage rate does not portray the complete picture of an average person. Furthermore, inflation continues to remain significantly lower than the Fed's target.

It is not possible for the U.S. economy to operate in isolation. The Fed needs to look at how the rest of the world's economies, especially larger economies, are doing. The second largest global economy, namely China, is slowing down and is expected to start the New Year on a weak note. It is expected to roll out another stimulus package to trigger growth and keep borrowing costs low. So, China is pursuing a low interest rate strategy. Similarly, Japan, which is the third largest economy, announced another stimulus package of $29.1 billion on December 27, 2014 to spur economic growth. The Japanese government is expecting real GDP to grow by 0.7% through this stimulus package. On the other hand, the European Central Bank has also hinted towards a quantitative easing program.

So, the second and third largest economies of the world have already announced a stimulus package to boost economic growth. Similarly, the European Central Bank is also thinking about quantitative easing. This means that global economies are slowing down, and I believe this will definitely impact the U.S. economy. The slacks in the labor market and inflation do not portray an encouraging outlook for the economy. The Bureau of Labor Statistics has also scheduled to report the December 2014 job data next week, which will make the job market situation clearer.

RMBS REITs to Avoid

ARR

In my last article on the company, I mentioned that due to the continuation of its defensive approach, its core EPS will remain under pressure and the management might be forced to cut down its dividends in the first quarter. This is exactly what happened, as the company reduced its monthly dividends by $0.01 per share to $0.04 per share.

The management's strategies have resulted in core EPS remaining under pressure and have resulted in the reduction in dividends. Firstly, the company has experienced a rise of $1 billion in the notional principal of swap in the third quarter. This was also accompanied by a rise in pay rate, which increased by 10bps to 1.60%. Even after remaining heavily hedged and paying a higher rate, ARR experienced a 6.5% decline in book value in the third quarter. Secondly, the company continues to remain heavily invested in low-yielding 15 and 20-year MBS, instead of high-yielding 30-year MBS.

Furthermore, the company continues to trade at a discount to its peers, which is justified, as it is a pure play agency RMBS and is not looking to diversify its asset base.

CYS

Just like its peer ARR, CYS continues to increase its swap position and the average pay rate on them. In the third quarter, CYS added $400 million in cancellable swaps. The swaps have a special feature that could be cancelled after one year if rates do not rise. However, the special feature comes with the extra cost, as the pay rate for the new swaps was 2.43%, which is significantly higher than the average pay rate of 1.39%. The company did increase its allocation to 30-year MBS in the third quarter, but if we look at the overall picture, the company continues to remain heavily invested in low-yielding 15-year MBS. CYS' portfolio is nearly 46% invested in 15-year MBS and only 36% is invested in 30-year MBS.

The company has already reduced its quarterly dividends in the third quarter by $0.02 per share. Currently, the company's core EPS covers its quarterly dividend payments, but if the management continues its defensive approach in the future, then it will have to access its dividend again. Based on my last article on the company, I expect a slight price appreciation, which is based on my price-to-book value multiple of 0.90x. I believe a 10% discount is justified due to its significant investment in agency RMBS.

Conclusion

I believe the Fed will be cautious in raising rates as long as the slacks continue to exist in the labor market. Furthermore, the largest economies of the world have announced stimulus packages to support the economy. Additionally, the European Central Bank has also hinted towards a quantitative easing program. Therefore, it will not be easy for the Fed to make its policy in isolation from global conditions. I believe both ARR's and CYS' core EPS will remain pressurized due to their defensive approaches. They both have already reduced their dividends, a key attraction for REITs investors, and they might do so again if they continue to follow the same approach.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.